Life insurance is a contract that provides your beneficiaries with a lump sum of money if you pass away, in exchange for regular scheduled payments today.
Life insurance is one of the most important purchases you can make, allowing you to protect the people who matter most to you.
While it might seem complicated at first glance, life insurance is actually pretty simple once you understand the basics and define your needs.
Below, we’ll give you a clearer idea of what life insurance is and why you should buy it.
How Does Life Insurance Work?
At its core, life insurance can be broken down into four basic elements:
- Policyholder: Usually the one insured, this individual is responsible for policy payments.
- Beneficiary: The person, group of people, or entity that receives the policy’s benefits.
- Premiums: The monthly or annual payments required to keep the policy active.
- Death benefit: The money the beneficiaries receive if the policyholder passes away while the policy is active.
Some policies come with additional components, but these are the basic elements of life insurance.
Unless you outlive the length of your policy, miss payments, lie on your application or breach its terms, the company will be obligated to pay out your policy as promised.
What Type of Life Insurance Do You Need?
At the most basic level, life insurance can be broken down into two types:
Which type of life insurance policy you should purchase depends on your financial needs, budget, and goals for the policy.
Term life insurance is made for temporary financial needs, offering coverage for a pre-determined “term” of time, like 10, 20, or 30 years.
If you pass away during the term and have made payments on time, your beneficiaries will receive the proceeds of your policy. Period.
Term life insurance is the simplest, most flexible, and most affordable option, making it the right fit for the majority of families.
Long-term needs might require permanent policies, which stay in effect for life as long as premiums are paid. They also come with cash value, a component that can accumulate interest and be accessed.
There are several types of permanent life insurance, including:
- Whole life insurance
- Universal life insurance
- Variable life insurance, and
- Indexed universal life insurance
All offer varying levels of flexibility and a variety of investment options.
Note that the lifelong guarantee and investment component make permanent coverage significantly more expensive than term.
How Much Does Life Insurance Cost?
How much you pay for life insurance is based on the amount and length of coverage you choose, the type of policy, and your risk.
The life insurance company will determine the cost of coverage by looking at risk factors like your:
- Health condition
- Family health history
- Tobacco use
Since young and healthy applicants get the best life rates, it’s important to purchase a policy ASAP if you need one.
Who Needs Life Insurance?
Anyone can benefit from life insurance, from singles with debt to bread-winning parents to retirees with massive estates.
A policy can provide for everything from a funeral to the taxes needed to settle a $50 million estate.
Here are a few considerations to help you decide if you need life insurance:
- Income replacement: Does someone depend on your paycheck for food, utilities, childcare, etc?
- Debt repayment: Do you share a mortgage, joint credit cards, or cosigned loans?
- Education: Do you want to ensure your kids are able to attend college if you pass away?
- Legacy: Would you like to leave your descendants with an inheritance, or give to a charity?
- Estate tax: Did you know high-income earners’ families could face estate or inheritance taxes?
- Business: Would your business survive if you or a key player passed away?
- Investing: Have you maxed out all of your retirement accounts and still want to invest?
- Final expenses: At the very least, do you have enough money saved to pay for your funeral?
If you’re debt-free, don’t have anyone depending on you, and have enough money to pay for final expenses, you’re probably safe to hold off on purchasing a policy.
Otherwise, life insurance is a must.
How Much Life Insurance Do You Need?
How much life insurance you need and can qualify for depends on your answers to the questions above.
While you may be tempted to take out an enormous policy that exceeds your family’s needs because coverage is so affordable, chances are you won’t get it.
It’s important to demonstrate to the life insurance company that the amount of coverage you apply for matches up to your actual needs.
Most agents and financial advisors suggest you purchase a policy that amounts to about 7 – 10x your income.
From there, you should factor in any additional expenses like debt, funeral costs, mortgage, and college tuition.
Last, subtract your liquid assets to land on the right amount of coverage you should purchase.
How Do You Buy Life Insurance?
While each company’s process will look a little different, here are a few basic steps you can follow to secure the policy you need:
- Research: Read reviews, get quotes, and compare multiple options to pick the right company.
- Apply: Your application may be online, on paper, over the phone, or in an agent’s office, and will include questions about your health and lifestyle.
- Take a medical exam: Some companies let you skip the exam at a slight additional cost, while others require you to undergo a checkup with a blood test.
- Sign and make a payment: Once your application is approved, you’ll sign off on your policy and make the first payment to get your policy in force.
If you opt for a traditional policy with a medical exam, the process above, known as underwriting, will take an average of 4 to 6 weeks.
However, some companies offer instant coverage when you skip the medical exam and apply online.
What Are the Advantages of Life Insurance?
In addition to protecting the people who matter most, here’s what you get when you purchase a life insurance policy:
One of the biggest advantages of life insurance is its tax structure.
When you pass away, the death benefit your beneficiaries receive is tax-free, meaning they’ll get every penny of the policy.
While there are a few unique circumstances that warrant taxation, beneficiaries don’t have to report the policy’s benefit as taxable income and normally won’t face any taxes.
With all of the policy types, terms, riders, and investing options, you can tailor a life insurance policy to meet your exact needs, altering your coverage as life changes.
You can get coverage anywhere from a year to your entire life and secure between a few thousand dollars of coverage and millions.
Whether you’re looking to see your kids through college, cover your mortgage, or permanently care for a dependent with special needs, you can mold a policy to those goals.
A lot of financial advisors are on the fence about using life insurance as an investment vehicle.
You’re likely to find traditional investing strategies to be a more rewarding and affordable option and shouldn’t purchase a permanent policy just for the cash value.
However, if you’ve maxed out all your other accounts and need permanent coverage, a whole or universal policy could be a good investment.
Most people overestimate the cost of coverage, but in reality, life insurance (especially term) is quite affordable.
In fact, our data shows the average cost of a $250,000 term policy for a 30-year old non-smoker is near $160 a year.
That’s close to what people pay for one or two of their streaming services, and it’s well worth the crucial protection it provides.